1 Reason to Buy Gold for Your Portfolio

Hailed by The New York Times as a "guru to Wall Street's gurus," value investing expert Bruce Greenwald takes some time to offer his insight and advice to The Motley Fool. A professor at Columbia University's Graduate School of Business, Greenwald has also authored multiple books, including Value Investing: from Graham to Buffett and Beyond.

Greenwald discusses the three asset classes that can make up a portfolio, and what kind of environment each one prefers. He also explains, once an investor has evaluated a portfolio's vulnerability to inflation and deflation, the three ways to hedge. These do include gold, as long as it's handled properly.

Full transcript below.

Bruce Greenwald: That means you've got now, I think, to take a fourth step as a value investor and ask yourself what's your vulnerability to inflation, on the one hand, and chronic deflation on the other?

I think they've always been sort of inflation sensitive, but I think there you'll see that there are three asset classes that you have.

You have real assets -- natural resources, companies that are competitive companies, real estate -- and there, you're going to do really well in an inflationary environment and you're going to suffer in a deflationary environment.

The second category are fixed income, and that does relatively well in a deflationary environment, and very badly in an inflationary environment.

Then there are the Nestles of the world, the franchise businesses, and they do well in both.

I think where value investors now start is, they either formally or informally do an inventory of their portfolio. How much of it -- and actually still, by historical standards, the franchise businesses are surprisingly cheap -- so they buy the cheap businesses with a good margin of safety, either in returns space or in value space for the non-franchise stocks.

They look at what they're left with, and they look at their vulnerability to inflation, and they look at their vulnerability to deflation. Then I think they think about hedging those things. There are three ways that you can hedge.

One is assets like gold that will do, typically, well if everything turns to crap. I think that's why you want to hold gold.

Now, there, there are two reasons. One is that it'll stabilize the notional value, but really the reason you want to have gold is everything turns to crap, it's not going to turn to crap permanently. It may turn to crap for a long time, but if you have the gold and you have the purchasing power, you'll get some real bargains.

On the other hand, if you're not psychologically conditioned so you can sell the gold and buy the stock in March of 2009, that substantially impairs the value of holding assets that are resistant to these systematic failures.

Matt Koppenheffer: You just end up keep holding that gold.

Greenwald: Right. You keep holding the gold, it's not as valuable as if you're somebody who can use it when it's most valuable in terms of what you can buy for it. That's one way to do it, is by assets that have negative correlations to bad economic conditions.

The second way to do it is with shorts. The problem with shorts is the tax treatment is terrible, that in general stocks outperform short term, which is typically what you're going to hold it in, so that you've got a headwind that's pretty substantial, at least 2-4%, and the risk characteristics are terrible, because if it doubles, your position is twice the size, not half the size.

The third way is with derivatives, puts of various sorts. The nice thing about derivatives is, if you look at 2007, derivatives were incredibly cheap. The implied volatility on the options that you could buy was under 10%.

It turns out the most dangerous times are when nobody thinks there's any danger, and those are the times where derivatives are cheapest. I think that's what good value investors have been led to think about, which is in these very fraught macro situations, what are the cheapest derivatives that you can get?

If they're very expensive, hey, you may just have to live with the gold as an alternative, or if there are some small shorts, you may have to live with that. But I think people have learned to think about their macro vulnerabilities when they think about managing risk, whereas I think in the past, they just would have ignored them.

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